Credit Default Swaps: central clearing yes, exchange trading no

According to BIS figures in notional terms the volumes of credit default swap (CDS) fell by 26.9% in the second halve of 2008 to $ 41.9 trillion. In December 2006 it amounted to $ 28.65 trillion, but then almost doubling to 57.89 trillion at the end of 2007.
The turn-around occurred against a background of severely strained credit markets combined with increased multilateral netting of offsetting positions by market participants. Single-name contracts declined to $25.7 trillion while multi-name contracts, a category that includes CDS indices and CDS index tranches, saw a decrease to $16.1 trillion. According to BIS figures of the total credit default swap volume some 60% were contracts with reporting dealers and 39% with other financial institutions. Non-financial customers held only a mere 1%.

Since the outbreak of the crisis and the demise of Bear Stearns, Lehman Brothers and in particular AIG, interbank lending became problematic and the monetary authorities had to step in. Very high levels of volatility combined with low liquidity in many financial markets. Uncertainty concerning total counterparty exposures became high. These factors have profoundly impacted yield curves, returning unexpected results and resulted in anomalies between counterparty and in-house valuations. Yet a massive fallout for the financial institutions involved in the credit derivatives contracts industry did not come about. However the credit derivatives industry and in particular the parties involved in over- the-counter-traded credit default swaps had become a key focus for politicians and regulators wanting to reform the world’s financial architecture.

POLICIES TO REDUCE CONCERNS

As a result banks became intensely focused on shrinking their balance sheets and allocating capital most productively. With a relatively small number of large dealing banks that both buy and sell protection against debt defaults many of these positions offset each other. Since the outbreak of the crisis the industry has increased efforts to eliminate such trades in a process known as “compression”. Those efforts accelerated in the second half of 2008 as the industry shrank the enormous notional volumes to address regulators’ concerns about the systemic risks posed by the market. Other recent activities involved standardization of contracts and “hard wiring”.

MARKET COMPOSITION AND GLOBAL DOMINANCE

Activity in credit default swaps in particular in the U.S. banking system is dominated by a small group of large financial institutions. At the end of December 2008 five large commercial banks (J.PMorgan Chase Bank NA, Bank of America, Citibank, Goldman Sachs and HBSC Bank) represented 99% of the total industry credit default swaps bought or sold. JPMorgan dwarves the others with a stake of nearly 53%. Citibank has a market share of nearly 18 % and Bank of America of 14%. The amount of $ 4.166 trillion credit default swaps contracts bought by JPMorgan Chase as measured for the US market alone indicates a worldwide share of at least some 10%.
The afore mentioned banks are also important in other parts of the world. In the letter to European Commissioner Charlie McCreevy, ISDA (representing participants in the privately negotiated derivatives industry) together with Barclays Capital, Citigroup Global Markets, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Morgan Stanley and UBS- or 7 out of the top 25 US commercial banks providing credit default swaps- committed themselves to use an EU-based CCP for eligible EU contracts by the end of July. Of the 14 financial institutions advising Japan to start clearing credit default swaps 6 represented affiliates out of the top 25 US commercial banks.
This domination also becomes clear when looking at the recent proposals of US secretary Geithner. In his letter to Congress he mentioned as targets:

Recordkeeping and reporting requirements (including audit trails).

Requirements for all trades not cleared by CCPs to be reported to a regulated trade repository.

CCPs and trade repositories must make aggregate data on open positions and trading volumes available to the public.

CCPs and trade repositories must make data on individual counterparty’s trades and positions available to federal regulators.

In particular realizing the last target is doubtful.
In line with the letter to mr McCreevy, in which IASD and the banks mentioned earlier confirmed their engagement to use EU-based central clearing for eligible EU CDS contracts by end-July 2009, ISDA jointly submitted a letter with market participants and industry associations to the Federal Reserve Bank of New York in which it stated that central counterparties (CCPs) were launched in 2009 for CDS markets.
From the ensuing reaction from the Federal Reserve Bank it is clear that all OTC derivatives transactions are to be registered in trade repositories or central counterparties. Regulators are thus enabled to monitor the OTC derivatives market and transparency to the public is increased. All derivatives trades are to be recorded by mid-July and centralized reporting infrastructures for interest rate and equity derivatives are established. By mid-December 2009 the risk reduction benefits of CDS Central Counterparties (CCPs) is to be extended to all market participants. Dealer clearinghouse participants have committed to provide their clients with access to any viable CDS CCP solution no later than December 15, 2009. Central clearing for standardized OTC derivatives instruments is the next step.
However, in both letters exchanges are not mentioned at all. Of importance is moreover that the only major Central Counter party launched in 2009 was ICE US Trust. This institution has the support of nine of the major global investment banks who are dealers in the CDS market, which includes Bank of America Corp., Citigroup Inc., Credit Suisse Group, Deutsche Bank AG, Goldman Sachs Group Inc., JPMorgan Chase & Co., Merrill Lynch & Co., Morgan Stanley and UBS AG. These banks are to receive a part of clearing revenues.
The other possible US central-clearing institution for credit default trades, CME, but this institution has thus far not been favored by the dealer banks.ICE Trust is readying for Europe. It has added Royal Bank of Scotland to its roster of clearing members and is ready to launch its central default swaps clearing counterparty in Europe in July. If the approach of the major banks is accepted by the European Commissioner two European clearers with a stock exchange background, Eurex (owned by Deutsche Boerse and Soffex) and NYSE-Euronext will be left in the dark.

POLICY QUESTIONS

The aforementioned developments carry the interest of the major banks. In the light of the highly specialized business of structuring, trading, and managing credit default transactions that require sophisticated tools and expertise, a case can be made for concentrating these activities in those institutions that have the resources needed to be able to operate this business in a safe and sound manner. Moreover settlement risk and systemic risk are reduced by the proposed measures.
However it is doubtful whether the market for credit default swaps is very competitive. Transparency of prices and price discovery probably remains limited. The dealers drive for profits can be against the interests of buyers of protection against credit defaults. The solution of concentrating central clearing in only one institution owned by mainly the same market participants probably is at odds with the goal of fighting systemic risks by bank supervisors. The least one can imagine is that monetary supervisors will try to stem those risks by more stringent capital requirements and intensive disclosure of activities etc. In the end in Europe it could be the European Commissioner for Competition Neelie Kroes who has the decisive vote.

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